Why Accounting for Financial Institutions is Key for Modeling Climate Mitigation Pathways

By Samantha Igo

A drastic shift in climate policies and investments will be necessary to meet the Paris Agreement climate targets, fostering responsible and inclusive economic transitions across the globe. 

Climate mitigation scenarios – such as those developed by the Network for Greening the Financial System, a reference platform of over 80 financial authorities known for sustainable finance – will be key in accomplishing a successful transition to low-carbon economies. These mitigation scenarios, which are generated with process-based Integrated Assessment Models (IAMs)  serve as the starting point for assessing possible risks and benefits of different strategies, bridging the gap between climate mitigation modeling and global financial regulation and risk assessment. But at this stage, they do not account for the role of financial actors and their expectations about climate change and policies. This is a main limitation to assess climate-related financial risk and to understand the feasibility, and conditions, of an orderly transition.

A new journal article published in Science Magazine and co-authored by Global Development Policy Center Non-Resident Fellow Irene Monasterolo finds that financial institutions are a key component for climate mitigation pathways, but are not accounted for in current climate economic modeling. There is an opportunity and need to complement current climate scenarios with the role of financial actors and their expectations. The financial system is usually considered in the policy discourse as an enabler for the low-carbon transition because it can provide the funding needed for the transition to a low-carbon economy. However, if investors come to believe that  missing the low-carbon transition would not be  a big risk for them, they will fail to trigger the reallocation of capital into low-carbon investments required for making the transition.

Accordingly, the financial system can play either an enabling or hampering role in the transition. Investors’ expectations (i.e., estimations on risk/return) about climate risks and policy credibility are the key features that can set the financial system to an enabling or a hampering role. On the one hand, if investors deem the policy credible, they could adjust expectations timely and reallocate capital into low-carbon investments early and gradually. In this way, they enable the transition, leading to smoother adjustments of the economy and of prices. In contrast, if investors do not deem the policy credible, they could delay revising their expectations, but then update them suddenly. This, in turn, could lead to abrupt changes in prices and financial instability, making the transition more costly for society.

In order to fully understand the role that the finance sector can play in supporting an orderly transition, a new generation of scenarios is needed to integrate the role of investors’ expectations and risk assessment. This leads to the opportunity to interface IAMs with models where investors carry out a climate-financial risk assessment (CFR).

“Our framework could support financial authorities in encouraging investors’ assessment of climate-related financial risk….Accounting for the role of the financial system also has implications for criteria used by central banks to identify eligible assets in their collateral frameworks and purchasing programs.”

Irene Monasterolo, BU Global Development Policy Center Non-Resident Fellow

The new article by Monasterolo and coauthors (from University of Zurich, Ca’ Foscari University of Venice, and the International Institute for Applied Systems Analysis) develops a framework to connect climate mitigation scenarios and financial risk assessment in a circular way, demonstrating the interplay between the role of the financial system (enabling or hampering) and the timing of the climate policy introduction. IAM generates sets of climate mitigation scenarios, which are then used by the CFR to model how investors assess the financial risk of high- and low-carbon firms along the IAM’s trajectories. The resulting trajectories of financing cost across low- and high-carbon firms are fed back to the IAMs to update the respective mitigation scenarios, closing the loop between the IAM and the CFR. The framework allows to derive scenarios that complement the current NGFS scenarios, strengthening climate financial risk assessment. By conditioning the investment decisions to the credibility of climate policy scenarios, the article considers how the role of the financial system as enabling or hampering can reverse the ordering of costs and benefits of climate mitigation policies, which are currently distorted by not considering the financial system.

This new analysis evaluates the feedback loop between financial systems and climate mitigation scenarios and can provide critical insights across finance and climate policy areas, such as:

• Fiscal policies guiding the phasing out of fossil fuels and phasing in of renewable energy subsidies;
• Allowing central banks to identify eligible assets in their collateral frameworks and purchasing programs, as well as monitoring and taming the possible moral hazard of the financial system in the dynamics of low-carbon transition; and 
• Mitigating the possibility of financial instability due to under allocation of capital into low-carbon assets or disorderly capital transitions.

As the globe grapples with the economic fall-out of the COVID-19 pandemic and the encroaching deadlines of the Paris Agreement and the 2030 Agenda for Sustainable Development, this new framework could be critical in facilitating an orderly transition to low-carbon economies and implementing other crucial climate policies.